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The world economy through a crystal ball

By Saul Eslake - posted Monday, 9 January 2006


The Nobel Prize winning physicist Niels Bohr (1885-1962) is supposed to have said, “Forecasting is difficult, especially when it’s about the future” (although the comment is often also attributed to that perennial phrase-mangler Yogi Berra). But if forecasting the future is difficult for physicists, it’s even more hazardous for economists. Our forecasts are often wrong - although as the Liberal MP and columnist Bert Kelly (1912-1997) used to say, if they were right most of the time about the things they try to forecast, they would be in the south of France with their feet in buckets of champagne rather than economists. Of course, if they’re wrong most of the time, they don’t stay as economists very long either.

Nonetheless, forecasting is part of what I get paid to do, so here goes.

When thinking about the world economy over the next five years one thing we can be reasonably sure about is that China will account for an even bigger share of it than it does today. Already, properly measured, China (not Japan) is the world’s second biggest economy. If the long-run forecasts of more than 250 economists compiled last October by Consensus Economics are borne out, by 2010 China will account for about 17½ per cent of global output - still in second place behind the United States, whose share of world output will have shrunk by a percentage point to about 21 per cent - compared with around 14½ per cent in 2005.

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Meanwhile India will have slipped past Japan into third place and - if oil prices stay relatively high, as seems likely if China continues to grow at the pace foreseen by the consensus forecast - Russia will have jumped from 9th to 6th.

One minor benefit of this re-shuffling of places at the top of the global economic league ladder is that France will no longer qualify - on the basis of its economic weight - for membership of the G8. So there might be a faint hope that a properly-constituted G8 could finally show some leadership on the question of agricultural trade reform.

Further down the scale, and again if the consensus forecasts are correct, Australia will have traded 16th place with currently 17th-ranked Taiwan - assuming that Taiwan is still near enough to a “country” in 2010 to figure in these rankings.

The problem with these consensus forecasts is that, for the most part, they merely extrapolate recent trends, with perhaps a cursory adjustment for demographic factors (although these don’t appear to have had much bearing on the rosy forecast for Russia, for example). Nowhere do they allow for a major cycle of recession and recovery.

One of the things that economists are particularly unsuccessful at is forecasting the timing of recessions. That’s partly because (fortunately) they don’t happen very often - typically once every 7-10 years in most advanced economies, except for Japan (where they’ve happened roughly every three years during the past decade) and Australia (where we haven’t had one now for 15 years). And (unfortunately) in some countries forecasting a recession can attract ridicule (OK, most of us can deal with that) or, more seriously, unwelcome regulatory attention or financial sanctions against one’s employer. All of which means that forecasting a recession can require a degree of intestinal fortitude as well as good judgment.

That said, it is hard to believe that, four years out from the last major slowdown in the world economy (following the “tech wreck” of 2000-01), we can expect to see another five years without a significant downturn in at least one major economy. Indeed, precisely because both economists and financial markets are currently assigning such low probabilities to such a downturn, investors need to be particularly attuned to the possibility that it could happen.

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Last year, when agencies such as the OECD or the IMF sounded their bi-annual warnings about risks to the global economy, they pointed to high oil prices, elevated house prices, large US budget deficits, and persistent and widening external imbalances between the US and other major economic blocs as possible triggers for an economic downturn.

However, the world economy has proved remarkably resilient to each of these risks. Without denying that these risks are real, it would therefore be problematic to premise a point-forecast for the world economy (or any individual economy) on any of them being realised.

I suspect that a greater risk, and one for which it is easier to be more specific about timing, emanates - ironically, given the current euphoria about its prospects - from China. China hasn’t had a significant downturn since the years immediately after the Tiananmen “incident” (as the Chinese authorities refer to it) of June 4, 1989, when real GDP growth dropped to an average of about 4 per cent for two years.

In recent years, however, China has begun to display some of the characteristics exhibited by Japan during the “bubble” years of the late 1980s. In particular, as a by-product of its determination (for reasons that, from a Chinese perspective, are perfectly understandable) to maintain a stable exchange rate, the People’s Bank of China has been printing trillions of renminbi in order to buy billions of US dollars. This is with a view to preventing the appreciation of the renminbi against the dollar that would otherwise have been the inevitable consequence of China’s swelling current account surplus and rising inflows of foreign investment.

This is exactly what the Bank of Japan did in the late 1980s - with the difference that it did so at the behest of the Americans (who did not want the US dollar to fall below ¥120), whereas the People’s Bank of China is doing it despite American pleas to allow the dollar to fall against the renminbi.

Just as occurred in Japan in the late 1980s, the People’s Bank of China’s currency-pegging operations have fuelled a massive monetary expansion, which they have been unable to fully “sterilise” via sales of Chinese Government or central bank paper to domestic financial institutions.

In 2004, a good deal of this “excess liquidity” found its way into the real estate markets of China’s booming cities, particularly Shanghai. Last year, rising property prices were suppressed by a combination of “window guidance” to Chinese banks to refrain from lending for speculative real estate ventures, and the imposition of capital gains taxes on real estate ventures by local or provincial authorities.

But as Chinese banks increasingly come under the influence of foreign shareholders and managers (who will be understandably looking for opportunities to make profitable loans), it will prove harder to keep this “bubble” under wraps by administrative measures such as these.

The 1980s Japanese bubble came to an end when it did because of a change in the leadership of the Bank of Japan in 1988. The newly installed governor, Yasushi Mieno, took the view that the bubble was undermining the moral fabric of Japanese society by encouraging the view that the path to wealth was no longer through working hard and saving lots, but instead through debt-funded speculation in shares and property. Mieno-san therefore took it upon himself to puncture the bubble by raising interest rates - even though there was no inflation in the traditional sense of rising consumer prices - until the bubble burst at the end of 1989.

It is surely not stretching the imagination too much to suggest that there may come a point where, if the “bubble” in Chinese asset markets re-emerges in the lead-up to the Beijing Olympics (as I think it will), the Chinese authorities may come to the view that an orgy of debt-fuelled speculation in urban real estate is inconsistent with the “socialist market economy” to which the Chinese Communist Party under Hu Jintao (more so than under Jiang Zemin) is ostensibly committed. Indeed they could be assisted in coming to that view by increasing resentment on the part of those not benefiting from such speculation, who might as a result begin to wonder about alternative possibilities for governing China.

Clearly the Chinese authorities would not implement any actions intended to burst a bubble in Chinese asset markets before the 2008 Olympics. But one of the key lessons of 1989 is that, if it comes to a choice between sustaining economic growth and sustaining the CCP’s monopoly of political power, the Chinese authorities will opt for the latter. They have no need to coin the Mandarin equivalent of “recession we had to have”.

Rather than raising interest rates, as Mieno-san did in Japan 16 years ago, bursting the Chinese bubble will entail the People’s Bank of China “pulling the plug” on the money-creation that is the by-product of its determination to keep the renminbi exchange rate stable.

The ramifications of this will extend far beyond China. If the People’s Bank of China scales back its purchases of US dollars - which over the past two years have averaged nearly US$200 billion per annum - then the US will find it harder to finance its current account and budget deficits. In the absence of any other source of financing, the US dollar will fall and US bond yields will rise, perhaps sharply. Higher US bond yields will translate into higher US mortgage rates (which, unlike in Australia, are priced off longer-term rates) and thence into a weaker US housing market and softer US consumer spending.

Indeed, it is quite possible that the next downturn in the US economy could be made in Beijing, rather than Washington. It is a sad reflection on the depth of understanding of how the international economy works these days that this is exactly what a majority of the US Congress, and a number of administration officials, would have Beijing do.

And just as global consequences of the US “panic” of 1907 served to announce the arrival of the US as “Top Nation” when everyone still thought Britain was, so to may the downturn of 2008 or 2009 serve as a harbinger of China’s eclipse of the US as the world’s largest (though far from the richest) economy some time after 2015.

The world hasn’t experienced a simultaneous downturn in its two largest economies since the mid-1970s. Even though prospects for Japan and (according to some) Germany are looking brighter now than they have done for some years, they aren’t large enough nor likely to be strong enough to offset the effect of simultaneous downturns in the US and China towards the end of this decade.

Nor can it be safely assumed that Australia will be able to slough off a global downturn in 2008 or 2009 as it did the Asian crisis of 1997-98 or the post-“tech wreck” global slowdown of 2001.

On each of those occasions, at least one of our major trading partners was booming - the US (and to a lesser extent) the EU in 1997-98, and China (which by then was already our fourth largest export market) in 2001. If the US and China experience simultaneous downturns in 2008-09, the stimulus (equivalent to more than one percentage point of GDP per annum) that we are currently enjoying from our rising terms of trade will go swiftly into reverse.

Nor can it be assumed that we can stave off a downturn by slashing interest rates, as the Reserve Bank did in 1997-98 and again in 2001. The Reserve Bank may well, and properly, cut interest rates in the event of a simultaneous downturn in the US and China in 2008-09. But, now that Australians have begun to (re-)learn that house prices can’t be relied upon to keep rising indefinitely, it is difficult to believe that this will spark a renewed upsurge in household borrowing and spending in the way that it did on those two earlier occasions.

Instead, and subject to any difficulties that we too may have in financing our own current account deficit, if and when, China turns off the money-tap, the only solution will be to open the fiscal floodgates with some combination of tax cuts and increased public spending. That would be the appropriate time for disbursing the revenues that are currently flooding into Canberra - rather than, as seems more likely, before the next election (due in 2007).

So a prudent five-year forecast should allow for the possibility that what may well extend into an 18 or 19-year streak of continuous growth in the Australian economy could come to an end some time during that period.

File this away for five years and - who knows? I’m unlikely to be in the south of France (dangerous place, these days); or I might be preparing another five-year forecast.

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About the Author

Saul Eslake is a Vice-Chancellor’s Fellow at the University of Tasmania.

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